Description

SCI Income Trust is a Canadian income trust that owns and operates the Simmons Canada mattress manufacturing company. All numbers discussed here are in Canadian dollars, and the units trade in Toronto. The unit is trading at $12 and the company pays a $1.08 annual dividend, for a current yield of 9.0% (or more like 9.8% if you assume a $0.10 special dividend at year end, as the company did last year). EPS is going to be around $1.35 to $1.40 for 2005, so the stock is trading at a P/E of under 9. The company has no debt and is trading at just over 6 times EBIT, or a pre-tax earnings yield of 16%. Alternatively its trading at around 5.5 times EBITDA. The company is a leader in its market, which is largely a steady and predictable business. This is basically just a cheap stock that provides current income plus is reasonably undervalued as a company. At a reasonable valuation of 8 times EBIT the stock would be at $15.30 (up 28% from here), plus in the meantime you get the 9% dividend. Also its likely the dividend will be increased, or supplemented by one-time special dividends, further increasing the yield, given the material difference between the $1.08 dividend rate and the company’s EPS rate (last year the company paid a special $0.10 dividend at year end, and given the cash balance it seems likely that will happen again this year). Alternatively if the stock were to trade to an 8% dividend yield based on a normalized dividend of perhaps $1.20 (which would be an 85% payout ratio on projected EPS), that would put the stock at $15.00.

Simmons Canada was acquired from Simmons USA in 1990 by Canadian management, and subsequently became one of the early Canadian income trusts in 1997. The company has a perpetual trademark and intellectual property license from the Simmons USA company for the use of the Simmons brand and all intellectually property developed by the US company. (The US company is now owned by Thomas H. Lee.) Simmons is one of the leading mattress manufacturers in Canada, with something like a 25% share of the Canadian market. Sealy has a similar market share in Canada, followed by Serta. The top 3 manufacturers have a 55%-60% market share, and the top 5 manufacturers have roughly a 75% market share.

The mattress industry is fairly predictable, with average annual growth of 3-4% (typically 2-3% volume growth on average plus a little pricing). See the two prior VIC write-ups on Sleep Country Canada, a leading retailer of mattresses in Canada, for additional industry information. Something like 70% of mattress purchases are replacement driven, with the balance driven by factors such as household formation, population growth, and housing starts. Also the mattress industry appears relatively immune from imports from low cost countries such as China – this appears to be driven by the combination of key strong brands having a grip on the market (e.g. Sealy, Simmons, Serta) and the costs of transporting the bulky mattress product. Simmons Canada has reported that imported products are estimated to be about 2% of the Canadian market, a number which hasn’t changed to any great extent over the last decade. Chinese manufacturers are attempting to grow in the North American market, but don’t appear to be making much progress and just aren’t a factor.

Simmons Canada’s performance has largely reflected slow but steady performance: After growing revenues from $105 mm in 1998 to $131 mm in 2002 (a 5-6% annual revenue growth rate), revenues were relatively flat in 2003 and 2004 due to certain issues that impacted results in those two years. Revenues fell slightly from $131 mm in 2002 to $129 mm in 2003, as a result of the SARS scare in early 2003 in Toronto as well as consumer anxiety around the start of the Iraq war (revenues were down 5.5% in the first half of the year, and operating margin declined from 12.7% to 7.4% as a result, but both volume and margins recovered in the second half of the year). In 2004, revenues were basically flat again at $129 mm, as a result of the company declining to renew a private label contract with Ikea at unprofitable pricing levels – as a result unit volume in 2004 was down 2%, but excluding the impact of the Ikea contract, unit volume would have been up 8% in 2004. Through the first three quarters of 2005, revenues are up about 6% versus 2004 levels, so the more typical growth pattern seems back on track. During this period EBIT fell from $15.5 mm in 2002 (an 11.8% EBIT margin) to $12.3 mm in 2003 (a depressed 9.5% EBIT margin due to the difficult first half of 2003 due to SARS), but then improved to $13.8 mm in 2004 (a 10.7% operating margin), and its looking like 2005 will end up with around $14.0 mm to $14.5 mm of EBIT. EPS during this period was $1.48 in 2002, $1.21 in 2003, $1.32 in 2004, and it’s looking like $1.35 to $1.40 in 2005.

To operate this business requires an investment of around $21 mm in receivables, $5 mm in inventory, $2 mm in prepaid expenses, and $15 mm of net PPE, partially financed by about $12 mm of payables, resulting in about $31 mm of net capital employed. On that capital base, the company generates around $14 mm of operating income (based on 2004 results although 2005 should be higher), or about a 45% pre-tax return on capital. That type of return suggests this is a pretty good business. Obviously they cannot reinvest capital at that kind of rate, otherwise this firm wouldn’t be in the income trust structure which is designed to minimize cash taxes while paying out most operating cash flow. But a respectable return on capital demonstrates the company likely has a decent competitive position that it has been able to maintain over time, and thus is likely to continue to generate similar returns.

There are 7.8 mm units outstanding at $12 each is a $93 mm market cap. The company is holding about $5 mm of cash, of which at least $3 mm is excess. So the enterprise value is about $90 mm. Relative to $13.8 mm of EBIT in 2004 and likely around $14.0-$14.5 mm EBIT in 2005, the company is trading at around 6.2 to 6.5 times EBIT, which is a modest valuation.

Additionally, note that the $1.35-$1.40 EPS for 2005 is tax affected at an effective rate of 22-23%. This compares to the standard Canadian corporate tax rate of 35%. However the company’s tax rate of 22-23% is materially higher than most Canadian income trusts, since the objective of putting a company into the income trust structure is to create a tax shield by installing debt between the operating company and the trust holding company (the debt is eliminated upon consolidation for reporting purposes since the holding company owns all the debt issued by the operating company). Since this company has been an income trust since 1997, effectively the company has outgrown its tax shield as the earnings of the operating company have grown, while the interest paid from the operating company to the trust (the holding company) has been fixed. There was a controversy in Canada this fall when the Minister of Finance launched a review of the income trust structure and threatened to eliminate the tax benefits of income trusts one way or another. This threat was lifted when it was announced the review was concluded early and no changes would be made – this seems to have been a politically motivated decision, given the growing importance of the income trust sector in Canada with high levels of retail and pension fund ownership. However note that even if the trust structure were to be eliminated at some point in the future (which would be very difficult to do politically), SCI’s EPS wouldn’t be impacted as much as other trusts, given it is already paying a material level of taxes. Moving the tax rate from 22-23% to 35% would move a $1.40 EPS estimate down to $1.17 – on that basis the stock at $12 is trading at a still reasonable P/E of 10.

A near term risk is related to issues the company noted in its Q3 2005 earnings release. As a result of the hurricanes in the gulf, the supply of polyurethane foam used to make mattresses was a concern, but the company’s supply was not impacted. However the price of this material increased around 40% on November 1, 2005 and the suppliers are talking about another 20% increase as of January 1, 2006. The company is working on strategies to offset these price increases – namely seeking price increases as well as re-engineering the product to reduce costs. Since this is an industry wide issue, all mattress manufacturers are facing this, and the thinking is they will be able to recover most of the increased costs through pricing actions and product re-engineering. While this will likely put some short term pressure on the company, it seems unlikely to be a disaster given that all manufacturers will be facing the same cost increases, and will all be seeking higher prices from the retailers. If this issue does negatively affect Simmons Canada for a few quarters, that could result in a great buying opportunity for the stock, since eventually foam pricing will likely get back to more normal levels, while any price increases the industry achieves could be stickier.

Another risk is obviously the risk of a big consumer slowdown. The first half of 2003 showed that sales and margins can and do go down when there is a shock to consumer spending, although the SARS scare in Toronto was a pretty unique situation. A slowdown in the housing industry could have a negative impact, since housing starts are a factor in driving mattress volume, but it’s mostly a replacement business. Certainly mattress replacements can be deferred when times are tough, but at some point people need to replace their mattresses. Of course, if there is a big consumer slowdown, virtually all stocks will be impacted. However the mattress industry has historically been pretty stable.

As a result of the foam supply issues and concerns about consumer spending, the two sell side analysts who follow Simmons Canada are projecting EBIT reductions of $0.5 mm to $0.8 mm in 2006. One of these analysts is projecting a $1 mm revenue decline in 2006 and the other is projecting a $3 mm revenue increase. So even with these concerns, the performance is likely going to be fairly steady and the stock is still cheap.

So to summarize, SCI Income Trust is a cheap stock, paying a 9% dividend and trading at under 9 times EPS. The company is a leader in its market, which is a fairly stable industry growing at a steady but modest clip, and the company has historically and consistently performed pretty well. There is one near term risk from foam pricing, which if it negatively impacts the company could actually result in a very good buying opportunity, since it seems likely any disruption in the typically steady earnings stream due to foam pricing will be temporary.


Disclaimer: We and our affiliates may be long SCI Income Trust, and may increase or decrease our position at any time. We have no obligation to inform anybody of any changes in our views of SCI Income Trust.

Catalyst

9-10% dividend yield.
Decent company just trading at too cheap of a price.